Outside the Box

Is the Bubble Economy Set to Burst?

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My friend Andy Xie, based in Shanghai, is a very independent-minded investment analyst and economist. With a PhD from MIT, he has been at the IMF and was a star economist for the Morgan Stanley Asia-Pacific group. His ofttimes bearish calls on various parts of the Chinese economy have elicited a lot of criticism from Chinese officials and retail investors. I have been on the stage with him several times, both on the same side of debates and on opposite sides – he is a formidable opponent! We do have one thing in common: While we may be often wrong, we are seldom in doubt and certainly not afraid of letting others know what we think. Forcefully.

This week Andy posted an essay in the South China Morning Post: “The bubble economy is set to burst, and US elections may well be the trigger.” I find that interesting. Here I am looking at the problems in China as potentially triggering global problems, and he is looking at elections in the US.

Andy says of himself that he has a reasonably good record at calling bubbles:

I wrote my doctoral thesis arguing that Japan was a bubble in late 1980s, a long report at the World Bank in the early 1990s arguing that Southeast Asia was a bubble, research notes at Morgan Stanley in 1999 calling dotcom boom a bubble, and numerous research notes from 2003 onwards arguing that the U.S. property market was a bubble. On the other hand I have never called something a bubble that turned out not to be a bubble.

In today’s Outside the Box Andy looks at what he thinks is the cause of the current bubbles that he sees around the world: central bank intervention. And I agree. I find it fascinating that Yellen & crew are puzzled at the lack of inflation in their CPI measure but don’t see a problem with inflation in asset prices. In fact, they see rising home prices and nosebleed-high stock prices as good things and are quite proud of having fostered those. The fact that they came along with credit bubbles around the globe, fostered by ultra-low rates, is something they are willing to ignore.

I know that Trump is going to be appointing a new Fed chair and Fed governors, but I have to tell you, there is simply not enough money to make me want to sit around that table and be responsible for cleaning up the mess that the present denizens have created. I think the FOMC is going to find itself in a situation where they have no good choices, and probably not even merely difficult ones. But they will be forced, or at least feel like they are forced, to “do something”; and that something is going to once again take the form of lower rates and more quantitative easing –and maybe even a few little innovations like negative rates and asking Trump and Congress for permission to shift out of their normal “We can only buy government-backed assets” mode. Much as the Bank of Japan, the ECB, and the Swiss National Bank have done. (Trivia: The Swiss National Bank owns almost 2% of Apple. How much more do they have to buy before they want a board seat? [That’s a joke, gentle reader.] But it does take 66 pages to print a list of all the stocks the SNB owns.)

I am more convinced than ever that we are rapidly moving into a world where the unthinkable –and I mean truly unthinkable – is going to be not only thought about but acted upon. Damn the torpedoes and all that stuff. I think you will enjoy Andy’s insights.

Now, the kitchen is calling me: I have a very large prime roast, chili, and mushrooms to make. Shane is also going to make chili for the guests that are a little less tolerant of “heat.”

There are some 15 independent advisors and brokers from around the country coming over, along with my various partners and associates. These evening dinners have evolved into a meet and greet with hors d’oeuvres and wine, then the food, and then we all move to the “family room” (it’s really just a big open space) where I sit on a high stool and answer questions. We start by asking these advisors what is the one thing their clients are most worried about and what is the one thing they themselves are most worried about. It makes for a provocative conversation.

I woke up yesterday morning finally feeling normal again and able to sit down and begin to work through my email inbox, where I found 415 messages. That’s after I deleted the obvious ones. Sigh – I know what I will be doing for a few days. You have a great week, and try not to let your inbox overwhelm you – get out and do something fun.

Your wondering how central banks get off the horns of this dilemma analyst,

The bubble economy is set to burst, and US elections may well be the trigger

Central banks continue to focus on consumption inflation, not asset inflation, in their decisions. Their attitude has supported one bubble after another. These bubbles have led to rising inequality and made mass consumer inflation less likely.

Since the 2008 financial crisis, asset inflation has fully recovered, and then some. The US household net worth is 34 per cent above the peak in 2007, versus 30 per cent for nominal GDP. China’s property value may have surpassed the total in the rest of the world combined. The world is stuck in a vicious cycle of asset bubbles, low consumer inflation, stagnant productivity and low wage growth.

The US Federal Reserve has indicated that it will begin to unwind its QE (quantitative easing) assets this month and raise the interest rate by another 25 basis points to 1.5 per cent. China has been clipping the debt wings of grey rhinos and pouring cold water on property speculation. They are worried about asset bubbles.

But, if recent history is any guide, when asset markets begin to tumble, they will reverse their actions and encourage debt binges again.

Recently, some central bankers have been puzzled by the breakdown of the Philipps Curve: that falling unemployment rates would lead to wage inflation first and consumer price inflation next. This shows how some of the most powerful people in the world operate on flimsy assumptions.

Despite low unemployment and widespread labour shortages, wage increases and inflation in Japan have been around zero for a quarter of a century. Western central bankers assumed that the same wouldn’t happen to them without understanding the underlying reasons.

The loss of competitiveness changes how macro policy works. Japan has been losing competitiveness against its Asian neighbours. As its population is small, relative to the regional total, lower wages in the region have exerted gravity on its labour market. This is the fundamental reason for the decoupling between the unemployment rate and wage trend.

The mistaken stimulus has the unintended consequences of dissipating real wealth and increasing inequality. American household net worth is at an all-time high of five times GDP, significantly higher than the bubble peaks of 4.1 times in 2000 and 4.7 in 2007, and far higher than the historical norm of three times GDP. On the other hand, US capital formation has stagnated for decades. The outlandish paper wealth is just the same asset at ever higher prices.

The inflation of paper wealth has a serious impact on inequality. The top 1 per cent in the US owns one-third of the wealth and the top 10 per cent owns three-quarters. Half of the people don’t even own stocks. Asset inflation will increase inequality by definition. Moreover, 90 per cent of the income growth since 2008 has gone to the top 1 per cent, partly due to their ability to cash out in the inflated asset market. An economy that depends on asset inflation always disproportionately benefits the asset-rich top 1 per cent.

There have been so many theories on why inequality has risen. The misguided monetary policy may be the culprit. Germany and Japan do not have significant asset bubbles. Their inequality is far less than in the Anglo-Saxon economies that have succumbed to the allure of financial speculation.

While Western central bankers can stop making things worse, only China can restore stability in the global economy. Consider that 800 million Chinese workers have become as productive as their Western counterparts, but are not even close in terms of consumption. This is the fundamental reason for the global imbalance.

China’s model is to subsidise investment. The resulting overcapacity inevitably devalues whatever its workers produce. That slows down wage rises and prolongs the deflationary pull. This is the reason that the Chinese currency has had a tendency to depreciate during its four decades of rapid growth, while other East Asian economies experienced currency appreciation during a similar period.

Overinvestment means destroying capital. The model can only be sustained through taxing the household sector to fill the gap. In addition to taking nearly half of the business labour outlay, China has invented the unique model of taxing the household sector through asset bubbles. The stock market was started with the explicit intention to subsidise state-owned enterprises. The most important asset bubble is the property market. It redistributes about 10 per cent of GDP to the government sector from the household sector.

The levies for subsidising investment keep consumption down and make the economy more dependent on investment and export. The government finds an ever-increasing need to raise levies and, hence, make the property bubble bigger. In tier-one cities, property costs are likely to be between 50 and 100 years of household income. At the peak of Japan’s property bubble, it was about 20 in Tokyo. China’s residential property value may have surpassed the total in the rest of the world combined.

How is this all going to end? Rising interest rates are usually the trigger. But we know the current bubble economy tends to keep inflation low through suppressing mass consumption and increasing overcapacity. It gives central bankers the excuse to keep the printing press on.

In 1929, Joseph Kennedy thought that, when a shoeshine boy was giving stock tips, the market had run out of fools. Today, that shoeshine boy would be a genius. In today’s bubble, central bankers and governments are fools. They can mobilise more resources to become bigger fools.

In 2000, the dotcom bubble burst because some firms were caught making up numbers. Today, you don’t need to make up numbers. What one needs is stories.

Hot stocks or property are sold like Hollywood stars. Rumour and innuendo will do the job. Nothing real is necessary.

In 2007, structured mortgage products exposed cash-short borrowers. The defaults snowballed. But, in China, leverage is always rolled over. Default is usually considered a political act. And it never snowballs: the government makes sure of it. In the US, the leverage is mostly in the government. It won’t default, because it can print money.

The most likely cause for the bubble to burst would be the rising political tension in the West. The bubble economy keeps squeezing the middle class, with more debt and less wages. The festering political tension could boil over. Radical politicians aiming for class struggle may rise to the top. The US midterm elections in 2018 and presidential election in 2020 are the events that could upend the applecart.

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Comments

Simon Maughan 48114

Oct. 31, 2017, 6:39 a.m.

This is fascinating analysis, but offers little to the investor in terms of timing. Anyone who describes themselves as calling bubbles in 1999 stocks and 2003 US housing, is good at describing economic cycles, not at calling bubbles. Mauldin has an army of these guys on tap, all arguing that economies are cyclical, but hemming and hawing about calling the top.

kmarkt2@yahoo.com

Oct. 26, 2017, 1:43 a.m.

The US midterm is a given and will not be a black swan. The only uncontrolled parameter is Mr Kim. A much needed implosion of the inverted wealth pyramid is a short nuclear engagement. That is the black swan.

gartha001@gmail.com

Oct. 25, 2017, 6:39 p.m.

“What get measured gets managed”.

I really liked the clear distinction between asset inflation and consumption inflation, recognizing that is the later that governments and central bankers focus their measurement and management on.

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